Equity returns are likely to remain muted, says Sanjay Mookim

With elevated price-earnings ratios, we recommend investors avoid risk in Indian equities, says Sanjay Mookim

Equity valuations remain high — while India continues to trade at a 50 per cent premium to emerging market (EM) multiples, earnings have been lacklustre. In this context, not many investors appear to be viewing India favourably for the next few months, SANJAY MOOKIM, India Equity Strategist, Bank of America Merrill Lynch, tells Puneet Wadhwa. Edited excerpts: 

How do you see flows to EMs pan out over the next one year? What about India?

Outflows, of both debt and equity from EMs, have increased recently. Several EM currencies have depreciated materially, prompting strong central bank action. A strong US dollar, combined with rising rates in the US, is likely to continue to result in outflows from EMs. Aggregate central bank liquidity injections are declining and are expected to turn negative in the second half of 2018. This should lead to further volatility in risk assets. EMs are likely to feel pressure from outflows through the rest of the year. India is unlikely to de-couple in this environment. Flows into or out of India should follow the same trend as for the rest of the EMs.

How are foreign investors viewing India amid all this? What are the key concerns? 
 

There seems to be little to distinguish near-term prospects for Indian equities from other EMs. Rising oil prices increase macro concerns for India. The current account deficit is increasing, fiscal targets are under stress, inflation seems to have an upward bias and domestic rates are hardening. Uncertainties related to the general elections in 2019 are a specific concern for the Indian stock market. Meanwhile, equity valuations remain high —India continues to trade at a 50 per cent premium to EM multiples, while earnings have been lacklustre. In this context, not many investors seem to be viewing India favourably for the next few months.

Are you planning to cut your December 2018 fair value of 32,000 for the Sensex? 
 

Our fair value estimate is based on a 16.5x multiple on estimated one-year forward earnings for the S&P BSE Sensex. We think FY19 earnings growth estimates are too high and are likely to be cut. However, we do not see a reason to lower our growth projections. The downside risk to our fair value could arise through lower valuations driven by the global risk appetites. While there are reasons to worry that the global tide is turning, we do not yet incorporate further multiples contraction in our assessment of Sensex’s fair value.

Are the markets factoring in the possibility of higher inflation, firm crude oil prices and rising interest rates?
 

No. The earnings estimates across the street do not seem to have built in these risks. Higher commodity prices will likely hurt margins for several consumer sectors. Rising interest rates and a weaker currency will hurt below the line; interest costs are likely to be higher and other income lower. Thus, few companies will beat expectations through FY19.
 

There are some signs of bottom-up improvement though. Rail freight volumes and electricity demand are improving. Cement consumption is recovering, while anecdotes of rural demand are strong. Industrial utilisations are also up year-on-year; some companies have started to explore Greenfield capex. These are good signs—the Indian business cycle should improve over time. The risk is that higher rates and commodity volatility dampen the nascent recovery. Over the next one year, stocks will respond more to earnings beats than to absolute earnings growth. Even if the micro recovery continues, it may not result in earnings surprises given high expectations. Equity returns are likely to remain muted.

Which sectors you prefer?
 

We are overweight on consumer discretionary (two-wheelers in particular), financials, industrials, utilities, cement, and underweight in healthcare, information technology, telecom and energy.

What’s your view on mid- and small-caps?
 

With elevated price-earnings ratios, we recommend investors avoid risk in Indian equities. That would mean we largely stay away from mid-caps as an asset allocation, though it is possible for some stocks in the space to continue to do well.

Pharma, realty and information technology sectors have done well in the recent weeks. What are your views as regards these three?

We see continued pricing pressure for Indian pharma companies in the US and are consequently cautious on the space top down. There seems to be some rotation into pharma – as a last corner of underperformance in the market – but this phenomenon should be finite.